Intrinsic value and
value investing

A lot is said about the notion of intrinsic value.
And a logical follow-on thought is that we should consider value investing.
Many investors accept conventional wisdom and follow this approach.
But in reality, are these ideas all they are cracked up to be?
Or are we better off considering an alternative?

Introduction

What
is intrinsic
value?
How do we calculate it? How useful is the notion of intrinsic value? Is
there a better substitute? What are the alternatives?

Oh,
by the way, here
are four sometimes
interchanged terms which are very similar, but perhaps a little
different: intrinsic
value, fair value, fundamental
value and true
worth.

The
other issue to mention here is that many readers might read through the
following material, and then choose to ignore the information because
it doesn't agree with their own views. This is one of the most common
forms of cognitive bias from which many investors suffer, and it is
what holds back many investors from being more successful. For more
details about cognitive biases and behavioural finance, see the
discussion on Emotion and
Psychology in the markets.

Value investing

The
idea of value
investing is based on the notion that a security is
cheaper than it should be, and that it will then appreciate to a price
that reflects its worth.

The
truth of this in practise is that it might not happen for quite a long
time, in which case the funds could have been better invested
elsewhere. The other possibility is that it might never happen - there
might be some other news that changes the situation completely. What if
Mister Market decides the share price needs to fall? And the price
falls and falls. This is capital destruction at work.

Is there an alternative?

Just
to digress for a moment, in case you are wondering if there is an
alternative, consider the following. The momentum, or trend following,
strategy is based on the notion that a security's price is more
likely to continue in the same direction than reverse. That is,
once a price trend is in place, it is likely to continue. This is
actually one of the six tenets of Dow Theory. One reason that this happens is based on the underlying emotion and
psychology of the markets.

Intrinsic value - a definition

Investopedia defines
intrinsic value
as:

The actual value of a company or
an asset based on an underlying perception of its true value including
all aspects of the business, in terms of both tangible and intangible
factors (source: www.investopedia.com/terms/i/intrinsicvalue.asp).

Wikipedia
defines intrinsic
value as:

In
finance, intrinsic value refers to the actual value of a company or
stock determined through fundamental analysis without reference to its
market value. It is also frequently called fundamental value. It is
ordinarily calculated by summing the future income generated by the
asset, and discounting it to the present value
(source: en.wikipedia.org/wiki/intrinsic_value).

Intrinsic value - simplified estimate

Benjamin
Graham
is widely acknowledged as offering a formula to determine intrinsic
value. This factors in the latest EPS, plus a forward estimate of
company growth (refer Wikipedia).
If everybody relied on this calculation method, things would be so
very straight forward. But people want an "edge" when investing in the
markets. They want a better way to do a more accurate job and to be
ahead of the other market participants.

Intrinsic value - how to calculate

A
common way to determine a company's intrinsic value is
to use fundamental
analysis. This
can involve the study of company financial reports, as published at key
times throughout the company's annual financial calendar.

It
is also possible to factor in a study of the company's management and
competitive advantages, as
well as it's markets and competitors. In fact, it could include the
study of anything which could impact on the viability and profitability
of the company and it's performance.

More
specifically, one might consider any or all of the following parameters
which can impact on a company's financial performance and it's intrinsic value:

Market price

It
is worth spending a moment to think about market price.
This is the amount of money that market participants are prepared to
pay for a company's shares today. If anyone thinks that a company's
shares are worth something quite different to the current market price,
then it doesn't really matter.

For
example, if CBA bank shares are trading on the market for $65, and
someone wants to sell their parcel at $75 each, there won't be any
buyers at that price. If someone has estimated that fair value is $75,
then it doesn't matter today, because no one wants to buy them at that
price.

Conversely,
if you think that CBA is actually worth $55, and it is trading at
around $65, no one will sell it to you for $55. You might want to buy
it at this price, and sit and wait for it to fall to this level. But it
might not come down. In fact, it might remain at it's current levels
for months or years, and possibly move higher, in which case you have
missed out on dividends and possible capital appreciation.

Intrinsic value - the reality

If
you ask a hundred
brokers and analysts what they believe is a fair price for the shares
of, say, Commonwealth Bank, what do you think the answer will be? How
many different answers will we get? Should we consider all their
recommendations and take a statistical average price, or a median
price?

Take
a look at the price chart at right (click on the image for a larger
version in a new window). This is a weekly price chart of CBA bank from
September 2010 until November 2013. Consider the following key points:

In the period September 2010 to July 2011, the share
price
fluctuated between a low of $47 and a high of $55. So anyone's opinions
about intrinsic value falling outside this range could not be realised
as no one was prepared to transact the shares at any other price. It
fell to a low about $43 in September 2011.

From this low, the share price then fluctuated up and
down in a range to a high of about $51 in March 2012.

From
the March low of $47.55 the price then ran upwards about 14 percent in
21 weeks. Then up another 14 percent in the next 31 weeks, and then
another 15 percent in the following 25 weeks.

Now through
all this time, anyone's opinion for intrinsic value pretty much didn't
matter a hoot.

Alternative?

Is
there a reasonable alternative? Well, don't forget that in reality,
almost everything that might influence a company's share price has
already been considered by the maajority of investors, and so is
already factored into the share price. That is, the share price chart
captures and summarises the collective opinions of the real market
participants. It is the market participants whose opinions about price
are captured in the price chart. If anyone believes that a stock is
"worth" something quite different to the value that it is traded for on
the market, then who is right? At the end of the day, it is the
so-called "Mister Market" who is right.

Conclusion

Why
spend all that time
reviewing company performance, and studying financial results, and
making assumptions to derive numbers to go into a spreadsheet model?
Is it really worth the time? Well, many retail investors do this
because they enjoy the activity. It's like any other hobby, or
enjoyable past-time.

It
is often argued by
some market participants that there is no need to spend so much time
on very detailed analyses. Because at the end of the day, the right
number for the “fair value” is the closing price on the share
market today. It is futile to argue against the market. Whatever the
market tells us about a share price is very close to the truth —
except of course for those people with inside information and who
might trade on this non-public knowledge.

And
the conclusion? For the absolute chartist (or technical analyst) who
believes that fundamental analysis is distracting and therefore almost
a total waste of time, it could be argued that paying attention to intrinsic value is
a total waste of time.

More information

The information presented herein
represents the
opinions of the web page content owner, and
are not recommendations or
endorsements of any product, method, strategy, etc.
For financial advice, a professional and licensed financial advisor
should be engaged.